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China waiting for a crisis: Andy Xie

Government must cut spending or wake up to a messy reckoning

By

AndyXie

BEIJING (Caixin Online) — Bank loans and money supply rose sharply in January. The timing of the Spring Festival may have distorted the data. Still, there are signs that many local governments with new leaders want to try an old trick, pushing fixed-asset investment (FAI) to create gross domestic product and fiscal revenue. This would turn bank loans into GDP and fiscal revenue.

Local governments are already heavily in debt. Pushing FAI would keep them liquid through new loans. It is essentially a pyramid scheme and can go on as long as the banks are willing and able to lend. But constraints have appeared.

Joining the World Trade Organization (WTO) and demographic dividends have sustained China’s FAI push for so long.

When an economy has underemployed factors of production like labor and natural resources, FAI, even though it isn’t profitable, can generate a positive return for the economy as a whole.

The increased income leads to more bank deposits that can sustain loans to loss-making FAI. Over the past two decades, this has been the case for China.

After China joined the World Trade Organization, foreign direct investment rushed in to take advantage of its labor surplus. It has built up the country’s export sector to the biggest in the world.

The export success has supported bank loans through increasing bank deposits within and supporting the exchange rate value without. The loans could support more FAI that would help expand export capacity. It is a virtuous cycle as long as the factors of production are still under-utilized and the export market healthy.

The virtuous cycle has come to a stop in the past few years.

The global financial crisis created a lasting barrier to China’s export growth. The country’s customers in developed countries literally went bust. Hence, there is no rising tide on the demand side for China’s exports anymore.

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On the supply side, the labor shortage first appeared five years ago. Three decades of the one-child policy, the expansion of the college system and the beginning of the retirement of the baby boomer generation born between 1950 and 1975 have worked together to decrease the blue-collar labor force.

The National Bureau of Statistics (NBS) announced that the labor age population shrank for the first time last year. This is why the blue-collar wages aren’t rising faster than labor productivity.

Despite declining producer price index due to overcapacity in the past year, consumer price index has continued to rise and will likely continue to do so in 2013. The money supply continues to rise much faster than potential growth rate. The difference is working into inflation through labor and other costs.

Inflation tax maxed out

In the past five years, the FAI boom lived off the inflation tax on two fronts. First, the negative real interest rate taxed savers to sustain the negative return on FAI. Second, the property bubble, now 25% of FAI, taxed buyers to boost government income that in turn supported a negative return of FAI.

The inflation tax has serious side effects. It cuts into the country’s competitiveness and threatens exchange rate stability.

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Like other export-led economies in East Asia, China experienced a property bubble during the export and investment boom. The difference is that the government in China controls all the land and gets most sales proceeds as revenue. It has motivated the government to push the bubble as far as possible. This is why China has both a price and quantity bubble.

The quantity side is especially severe. NBS data showed that 10.6 billion square meters of properties were under construction at the end of last year, of which half were residential and the other half office and commercial.

An average price close to the market price now would put the value of this inventory at around 1.5 times GDP. Such a high level of inventory value has never occurred anywhere else. It is hard to imagine where the money would come from to absorb it.

The economic fundamentals require China to slow monetary growth to about 10%. The inventory digestion would demand 20% to 30$. This is why so many vested interests complain that today’s monetary condition is too tight.

Last year’s M2 growth rate of 13.8% is low relative to the average of 18.2% between 2000 and 2012. It is still too high for price stability. If the M2 growth rate rose to 20%, not only would inflation surge, the exchange rate would tumble.

These constraints may force the government to control the rate of monetary growth despite the pressure from vested interests that need to liquidate inventory.

The dead cat bounce

In the past three months, the property market has recovered in tier-one cities. It has led to spreading market optimism that the bubble is intact. I disagree. This is just a bounce in a multiyear slide.

My view is based on the constraints to money supply growth. Any acceleration in monetary growth, as is the case now, is short-lived. The inflation and devaluation pressure will trigger money to flow offshore.

Recent corruption cases exposed on the Internet suggest that the vast amount of corruption income is mainly in the property market. This explains the size of the bubble.

While the price-to-income ratio is similar to what Hong Kong experienced in the mid-1990s and Japan in the 1980s, China’s market volume is unprecedented. The bubble could be so big due to the tendency for money supply to become corruption income and the latter to become property demand.

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